FINANCIAL STATEMENT ANALYSIS 1 The examination of both the relationships among financial statement numbers and the trends in those numbers over time a Purposes i Use the past performance of a company to predict how it will ii Evaluate the performance of a company with an eye towards do in the future identifying problem areas b Always issued with the previous year s financial statement sometimes even the previous two years i Comparative Financial Statements c Horizontal Analysis Trend Analysis Technique for evaluating a series of financial statement data over a period of time i Expressed as a percentage of the same item in the financial statements of another year base year ii Current Year Sales Base Year Sales Base Year Sales iii Amount column is additive the percentage column is not d Vertical Analysis Technique that involves expressing each item in the financial statements as a percentage of a base amount within one year i Financial statements that recast all items on the statement as a percentage of a selected item are Common size financial statements 1 Best for comparing companies of different sizes e Ratio Analysis The most common way of comparing accounting numbers to evaluate the performance and risk of a firm i Liquidity Ratios Measures short term ability of a company to pay its maturing obligations and meet any unexpected needs for cash 1 Working capital Total current assets total current liabilities liabilities 2 Current Ratio Total current assets total current a 1 67 Every dollar of current liabilities the company has 1 67 of current assets 3 Acid test ratio Cash short term investments Receivables Total current liabilities a Firm s ability to meet current obligations even if none of the inventory can be sold 4 Current Cash Debt Coverage Net cash flows from operating activities Average total current liabilities 5 Accounts Receivable Turnover Ratio Net sales revenue Average accounts receivable a Number of times a company is able to collect receivables during the accounting period b Avg Inventory AR 1 1 AR 12 31 2 6 Average Collection Period 365 Accounts receivable turnover ratio a Number of days on average between selling goods to credit customers and collecting cash from those sales 7 Inventory Turnover Ratio Cost of goods sold average inventory a Number of times on average that inventory is sold during the accounting period b Avg Inventory Inv 1 1 Inv 12 31 2 8 Number of Days Sales in Inventory 365 Inventory turnover ratio a Number of days on average between purchasing inventory from suppliers and selling the inventory to customers ii Probability Ratios Measures the income or operating success of a company for a given period of time iii Solvency Ratios Measures the ability of the company to survive over long period of time f Profitability Ratios Answers the questions can the company generate a satisfactory rate of return i Gross Margin Profit Rate Gross Profit Net Sales Revenue 1 Percentage of the selling price of inventory that is gross 2 profit Indicates a company s ability to maintain a selling price above its cost of goods sol a Declines as industry is more competitive ii Profit Margin Ratio Net Income Net Sales Revenue 1 Measures percentage of each dollar of sales that results in net income 2 High volume high inventory turnover businesses like grocery stores and pharmacy chains generally have low profit margins a Very little of their sales actually end up in profits iii Return on Assets Net Income Average Total Assets 1 Measures overall profitability of assets in terms of the income earned on each dollar invested in assets 2 Average Total Assets Total Assets 1 1 Total Assets 12 31 2 iv Return on Equity Net Income Average Total Equity 1 Measures how many dollars of net income the company earned for each dollar invested by stockholders 2 Average Total Equity Total Equity 1 1 Total v Earnings Per Share Net Income Number of Common Equity 12 31 2 Shares Outstanding 1 Measures the amount of net income associated with each share of common stock 2 Tells a stockholder how much of a company s net income is associated with his ownership interest a Own 10 EPS 2 you have 20 of the company s net income 3 ONLY RATIO REQUIRED TO BE SHOWN IN THE FINANCIAL STATEMENTS vi Price Earning Ratio Market Price Per Share of Common Stock Earnings Per Share 1 Measures investors expectations regarding the growth potential and earnings stability of a company 2 Higher P E ratios indicate the market is more optimistic about growth potential of the company g Solvency Ratios Can the company survive over a long period of time i Debt to Equity Ratio Total Liabilities Total Stockholders Equity 1 1 30 Ratio means Liabilities are 30 larger than equity 2 Measure of creditors protection in the evnt of the company not being able to pay its debts Insolvency a Higher Debt Equity ratio Higher risk for b Greater creditor claims on assets so higher likelihood an individual creditor would not be paid in full if the company can t meet obligations c Also means higher interest rate charged by creditors lenders ii Times Interest Earned Ratio Net Income Income Tax Expense Interest Expense Interest Expense 1 Measures the company s ability to meet it s interest payments as they come due 2 Margin of safety provided to creditors 3 Higher the more income the company has to pay its interests and the less likely the company is to default on these payments h A ratio by itself does not give much information it must be compared to ratios from previous periods ratios of other companies or industry averages MODULE 5 PRACTICE PROBLEMS